Making the Simple Complicated

The basic economics of climate change seems simple. Scientists tell us that carbon emissions put the planet at risk. The environmental impact of energy use represents a classic externality, a case in which an individual’s private actions affect the larger world. Following the great English economist Arthur Cecil Pigou, economists have long argued that such externalities can be treated with a tax equal to the size of the externality. In this case, the right tax would equal the worldwide economic damage wrought by emitting carbon or other greenhouse gases. So why is the Kerry-Lieberman climate change bill, the grandly named American Power Act, 987 pages long?

This bill is a behemoth for three reasons. First, it tries to do far more than just charge for carbon emissions. The bill starts by providing “incentives for the growth of safe domestic nuclear and nuclear-related industries.” It supports carbon capture in coal plants, expands offshore drilling, establishes an Office of Consumer Advocacy and promotes “clean energy career development.” Standard economics suggests that many of these interventions would be unnecessary if we had the right tax on carbon emissions; if companies pay the full social costs of their actions, they have the right incentives to invest in greener technologies without any further help from Uncle Sam.

The second reason that the bill is so big is that it uses a complicated cap-and-trade system rather than a simple Pigouvian tax. In theory, a permit system can be identical to a tax. Selling permits to emit carbon at $50 a ton is equivalent to taxing carbon emissions at $50 a ton. But tradeable permits, typically and as promulgated in the American Power Act, differ from a tax for two reasons: the quantity of permits is relatively fixed, and many permits will be given away rather than sold.

Fixing the number of permits may actually be the right thing to do. As my colleague Martin Weitzman wrote almost 40 years ago, quantity controls are better than prices if we are more certain about the right quantity than we are about the right tax. In the case of global warming, we may arguably be more confident that the amount of carbon should stay relatively flat than we are about the per-ton damage from carbon emissions.

Giving away permits rather than selling them is often defended as a means of ensuring that global warming doesn’t become an excuse for higher taxes. A carbon tax could easily get out of hand if the public sector starts seeing it as a solution to America’s budgetary shortfalls. Freely distributing permits seems to be crucial in building support for the bill, but the cost in simplicity is significant.

International trade is a third reason that this bill is so complicated, because we are trying to use domestic legislation to handle a global externality. If America charges for the carbon emissions involved in making an industrial product but our trading partners do not, then American producers will be at a competitive disadvantage.

This would not only hurt America’s industrial base but would also make a domestic cap-and-trade program less effective at reducing carbon emissions. At the extreme, a sufficiently high energy charge could lead an American industry to shut down and be replaced by new production in places with no restrictions on carbon leading. This scenario results in 100 percent “carbon leakage” and no net reduction in emissions.

The bill tries to deal with this problem with abundant exhortations to sign effective international carbon-control treaties. If such treaties fail to materialize, the United States may start charging imports for the carbon used in their production.

While I understand the economic and political logic behind this approach, it is a distinctly dangerous path. Our trading partners will argue that these charges are tariffs in disguise. Moreover, the United States won’t have the data to figure out which international producers are green and which are brown, making us singularly ill-suited to impose carbon charges.

A less problematic way to address the international problem is to charge domestic companies based on their carbon emissions, then rebate the tax industry by industry, based on individual companies’ sales. If the domestic widget industry pays a billion dollars for carbon emission permits, then those billion dollars get rebated in the form of tax credits to the industry, with shares based on the number of widgets sold. The rebate ensures that the widget industry wouldn’t be particularly hurt vis-à-vis its international competitors. This solution is far worse than a global carbon tax, but far better than starting a trade war.

At the end of the day, it is hard to relish either this ornate piece of legislation or the prospect of inaction on global emissions. This is one of the many times when I’m grateful that I don’t have a vote on Capitol Hill.

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